Fundamentals pointed to more of the same underwhelming growth picture. In keeping with the trend in recent months, risk sentiment remained robust despite a tepid fundamental backdrop that was largely unchanged. Economic indicators in the U.S. continued to paint a muddled outlook with impressive labor market gains, robust personal spending and confidence figures offset by a slight downward revision to Q2 GDP. In a reversal from July, U.K. sentiment rebounded considerably, while “hard” economic data, such as unemployment, retail sales and GDP, also impressed. The Bank of England (BOE) launched its stimulus package as promised, including its first interest rate cut in seven years. As the U.K. economy shrugged off Brexit worries for the time being, Europe’s concerns grew. Sentiment among German businesses took a steep dive, and eurozone PMI fell nearly one point, though at 52.0 it remained in expansionary territory. In stark contrast to last August, when a surprise currency devaluation spurred a dramatic market sell-off, China news was notably light. Despite weakening Chinese industrial production, softening retail sales and slowing credit growth, markets managed to maintain an almost eerie calm.

Markets continued to rally in the absence of left tail economic surprises. Many of the market trends evident in July continued into August as risk assets gained. Healthy risk appetite was apparent and credit spreads ‒ high yield, in particular ‒ tightened on the month. Equities were only modestly higher, but the three major U.S. indexes set all-time records early in the month. Implied volatility, as measured by the VIX Index, remained well below long-term averages; August’s daily average was the lowest in the past two years. Even U.S. 10-year Treasury yields remained remarkably range-bound, though the yield curve flattened and the dollar moved higher as Fed Chair Yellen’s Jackson Hole address was perceived to be hawkish. The current economic and financial market configuration is far from the marvel of Willy Wonka’s Chocolate Factory, but it does make one wonder: With unprecedented levels of central bank support around the world unable to stop the global economy from becoming increasingly fragile, the U.S. mired in lackluster growth in the eighth year of an expansion, and yet sovereign yields at all-time lows and equities at all-time highs, is it real, or is it pure imagination?

In the markets

World Records
While Usain Bolt and Katie Ledecky were breaking records at the Rio Olympics, the three major U.S. equity indexes (Dow Jones, Nasdaq and S&P 500) simultaneously set all-time highs in mid-August, an alignment that has not happened since 1999. Momentum from July – with a continued building in investor risk appetite – carried the markets to their new highs. Equities have remained buoyant amid low interest rates and a generally resilient economy, marking a sharp turnaround from earlier in the year when recession fears gripped markets. Despite the new records, equity markets closed the month on a more subdued note as Fed Chair Yellen’s address at the Jackson Hole symposium pushed expectations higher for the next Fed rate hike, possibly as early as September.

EQUITIES

Developed market equities¹ returned 0.1% during the month, trading range-bound amid muted volumes as investors awaited central bankers’ next policy moves. In Europe,² stocks rose 0.7%, while U.S. equities³ ended the month flat, returning 0.1%. Japanese equities⁴ outperformed most developed markets, returning 2.0% on a slightly weaker yen and dovish rhetoric from the BOJ at Jackson Hole.

In emerging markets,⁵ equities rose 2.5% as stabilizing macro fundamentals, combined with low to negative yields in developed markets, continued to drive flows into risk assets. Brazilian stocks⁶ extended their gains, returning 1.0% amid the anticipation and realization of former President Dilma Rousseff’s impeachment, paving the way for fiscal reform. Chinese equities⁷ advanced 3.7% following the approval of a second trading link from Hong Kong to mainland markets and loosening of foreign investment limits. Indian equities⁸ also ended the month positive, returning 1.5%, while Russian equities⁹ advanced 1.4% on a rebound in oil prices.

DEVELOPED MARKET DEBT

Against the benign global backdrop, developed market yields generally drifted higher over the month. Observers closely followed policymakers’ comments at Jackson Hole, and market expectations for at least one U.S. rate hike in 2016 rose to nearly 60% after Janet Yellen communicated that improving economic data strengthened the case for a rate hike as soon as September. Two-year Treasury yields, which are more sensitive to Fed rate hike expectations, rose nearly 20 basis points (bps), and the curve flattened. Japanese yields spiked early in the month on disappointment with the Bank of Japan’s (BOJ’s) stimulus package announced last month, while yields in Europe continued to trend higher in the absence of major left tail economic surprises. U.K. yields proved the exception, as 30-year rates rallied nearly 30 bps after the Bank of England (BOE) cut its base rate by 25 bps and launched a bond-buying program.

INFLATION-LINKED DEBT

Global inflation-linked bond (ILB) markets posted gains for the month,
led by the U.K. after the Bank of England introduced additional easing measures early in the month. In the U.S., real rates on Treasury Inflation Protected Securities (TIPS) followed nominal yields higher on the back of better economic data, including a strong July payrolls report. Following recent flattening, the U.S. breakeven inflation curve steepened despite higher oil prices as headline Consumer Price Index (CPI) came in below expectations. U.K. index-linked gilts saw strong outperformance versus their nominal counterparts in August, with breakevens supported by an upside surprise to the Retail Price Index (RPI), stronger demand from domestic accounts, and a modest decline in the pound. Among European ILBs, peripheral countries outpaced core issuers in a continuation of the post-Brexit recovery, with additional support coming from a modest upside surprise to August’s preliminary Italian Harmonised Index of Consumer Prices (HICP) figures.

CREDIT

Global investment grade credit spreads¹⁰ continued to rally in August, tightening another 9 bps alongside continued global monetary policy support and a recovery in commodity prices following a brief sell-off in July. Year-to-date total returns for global investment grade credit stand at 8.3%, as low yields globally continue to be a key driver of demand for credit and should remain favorable for spreads.

Global high yield bond yields¹¹ reached a 16-month low in August amid easing global macro concerns, an improving backdrop for commodities and accommodative central banks. With spreads down about 55 bps for the month (and 160 bps for the year), global high yield bonds have posted their seventh consecutive month of positive returns, up 2.2% in August and 13.2% year-to-date.

EMERGING MARKET DEBT

EM debt posted modestly positive returns in August, as risk assets continued to perform well despite renewed expectations of a Fed rate hike later this year. Spreads over Treasuries for external debt narrowed, EM local yields were flat, and currencies generally strengthened modestly against the U.S. dollar. Developed market yields remained anchored near all-time lows, lending support to EM assets, and stronger energy prices and idiosyncratic political events also drove performance in select markets. In South Africa, a weak showing by the ruling party in local elections drove down yields and strengthened the rand. Elsewhere, Brazilian yields fell and the real appreciated following the formal removal of President Rousseff from office.

MORTGAGE-BACKED SECURITIES

Agency MBS¹² outperformed like-duration Treasuries by 32 bps, bringing year-to-date excess returns to +11 bps. Ginnie Mae MBS outperformed conventional MBS, 30-year MBS outperformed 15-year MBS, and higher coupons outperformed lower coupons within 30-year conventional mortgages. July prepayments, reported in early August, declined by 7%, and the average refinancing index for August also declined 9%. Non-agency MBS prices increased and spreads tightened amid continued favorable market technicals and stable residential real estate fundamentals. Non-agency commercial MBS¹³ (CMBS) was also strong, outperforming like-duration Treasuries by 63 bps. CMBS technicals have been favorable given the slower pace of new issuance year-to-date and continued investor interest in high quality spread assets.

MUNICIPAL BONDS

Municipals were up modestly during the quiet trading month, as they outperformed Treasuries across the curve: Long-dated muni yields were anchored, while the front end drifted slightly higher as the market weighed the possibility of a September rate hike. The trend of strong demand absorbing steady supply continued. Refunding was behind much of the $44 billion in August supply, as issuers – most notably, the State of California – took advantage of low interest rates to refinance outstanding debt. Puerto Rico’s federally led restructuring efforts took a first step forward as President Obama appointed seven members to the island’s new financial oversight board. This bipartisan group will work with the governor to draft a fiscal plan that should form the basis of negotiations with creditors.

CURRENCIES

The dollar strengthened modestly against most developed market currencies in August as the market-implied probability of a rate hike at the next Fed meeting steadily increased. The British pound weakened after the Bank of England delivered a strong easing package alongside a cut in the policy rate, while the Japanese yen declined following the government’s introduction of a new fiscal stimulus package early in the month, fueling speculation over future policy coordination. Among emerging markets, idiosyncratic political issues drove currency strength in South Africa, where the ruling party was roundly defeated in local elections, and in Brazil, where President Rousseff was formally impeached and removed from office.

COMMODITIES

Performance was mixed among commodities sectors, with energy posting gains but agriculture and metals selling off. Crude oil prices were supported in part by generally positive International Energy Agency (IEA) data, including improving balances, as well as favorable technicals (short covering). Headlines on refinery cuts provided additional support to petroleum products, which generally outperformed the already notable gains in crude. Natural gas was down as production recovered more than many had expected. Agriculture was also negative as wheat, corn and soybeans all sank meaningfully following a bearish USDA report on new crop yields that surpassed all expectations. Precious metals were down, owing largely to technicals in the absence of any noteworthy shifts in fundamentals. Base metal prices also came under pressure due, in part, to a rise in London Metal Exchange (LME) inventories and news that Chinese local governments were evaluating options to cool rising home prices.

Outlook**

PIMCO expects global economic and policy divergence will continue to provide a mix of risks, opportunities and volatility. While most markets remain in positive territory despite the downturn early in the year and even after the surprise “Brexit” vote, our 2016 forecasts for global growth and inflation remain low in light of weaker economic momentum as well as the tightening in financial conditions that occurred at the beginning of the year. Importantly, we do not expect a global or U.S. recession over the cyclical horizon. While the three C’s – China, commodities and central banks – have been calmer recently, their paths forward remain key swing factors for the global outlook.

In the U.S., our expectation is for above-trend economic growth in a 1.75%–2.25% range in 2016. We expect the “delicate handoff” from slowing job growth to higher wages to succeed as the main driver of income creation, supporting further gains in consumer spending. Assuming steadier crude oil prices, headline inflation (as measured by the CPI) is likely to hover in the 1.0%‒1.5% range before rising toward 2% by end of this year/early next year. With PCE inflation (personal consumption expenditures inflation, which is expected to run about 0.5% below CPI inflation) remaining below the Fed’s 2% target and global developments still posing considerable risks to the outlook, we expect the Fed to be even more cautious on its path to normalizing rates.

For the eurozone, we anticipate trend-like GDP growth in the 1.25%-1.75% range. We expect the headwinds for growth from weak global demand and the tightening of financial conditions earlier this year to be roughly offset by the lagged effects of the weaker euro on exports, and for low oil prices and rising employment to support consumption. The uncertainty associated with the surprise outcome of the U.K. referendum is another factor alongside persistently low inflation that may spur the ECB to do even more.

Japanese GDP growth will likely be in the 0.25%–0.75% range in 2016. With China slowing and the yen appreciating this year, the external sector will continue to be a small drag for economic activity. Inflation looks set to continue to fall short of the BOJ’s 2% target – our forecast is for headline inflation in a range of 0.25%–0.75%. Against this backdrop, further easing measures by the BOJ could be likely during the year.

Our outlook for China is for growth in a 5.5%-6.5% range and headline inflation around 1.25%. China’s transition from “old” (industrial, state-owned and export-oriented) to “new” (service sector, private and consumption-oriented) growth drivers continues to sputter. As such, we expect “official” GDP growth to fall short of the government’s 6.5%–7% target range for three reasons: room for monetary policy easing is limited as it could accelerate capital outflows and put downward pressure on the yuan; the government seems unwilling to meaningfully expand fiscal policy; and volatility in the equity market and overcapacity in the property market have increased uncertainty, weighing on consumer confidence.

We expect BRIM growth will be in line with consensus at 0.75%–1.25%. India is forecast to grow at a 7.3% pace this year, about the same as last year, while Mexico should see a slight acceleration to 2.8% growth this year. In Brazil, the political situation remains fluid with many market participants suggesting that a regime change could provide a catalyst for reforms. In Russia, we think the sharp adjustment in unit labor costs presents an opportunity to rebalance the economy longer-term, and a continued recovery in oil prices would help to end the current recession.

** Note that growth and inflation forecasts are published following PIMCO’s quarterly cyclical forums. Forecasts shown are based on our March cyclical forum and will be updated at the next cyclical forum in September.

In Sight

A FLIP-FLOP KIND OF SUMMER FOR OIL

Oil prices, like oil-related headlines, have fluctuated considerably this summer: Prices fell from a June high of more than $50 per barrel to nearly $40 in early August, only to rebound to $50 just two weeks later. These recent gyrations have been fueled in part by headlines of a possible output freeze when large oil exporters meet for informal discussions at an energy forum in Algeria in late September. But even if implemented, a freeze is unlikely to meaningfully impact oil prices because OPEC production is now running near capacity: Saudi Arabian production is at its peak and growing supply from Iran has effectively offset production declines in Nigeria and Libya (caused by local militant groups). While OPEC supply is unlikely to affect prices much near-term, declining U.S. production and healthy global demand – with strong U.S. growth outweighing weaker emerging markets and mixed Chinese consumption –should provide support for prices. In the absence of a more significant catalyst to break the pattern, we expect oil prices to be in the $50–$55 range next year, even if summer flip-flopping continues into autumn.

Appendix

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation- Protected Securities (TIPS) are ILBs issued by the U.S. government. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world.

©2016, PIMCO.

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